Stock Market Optimism is Becoming Contagious

Earnings and dividend increases are driving strong bull sentiment

“The key to making money in stocks is not to get scared out of them.” – Peter Lynch

I’ll sum up this market up in four words: Fear is melting away. Wall Street continues to rally as the fear that gripped the market so intensely slowly fades away, and this has been great news for the broader market.

On Thursday, the S&P 500 closed at its highest level in more than five years before giving some back on Friday. What’s even more impressive is that the Volatility Index (TSE:VIX), also known as the Fear Index, recently dropped to its lowest level in five-and-a-half years. After seven days of trading, our Buy List is already up 4.34% for the year, which is 1.12% ahead of the S&P 500.

Earnings season is about to start, and we had a flurry of good news this past week. Both Stryker (NYSE:SYK) and Medtronic (NYSE:MDT) raised the low end of their full-year guidance. DirecTV NYSE:DTV) rallied after the company said it had added 100,000 new subscribers in Q4.

How about Nicholas Financial (NASDAQ:NICK)? The little powerhouse came close to breaking through $14 per share. On Thursday, Oracle (NASDAQ:ORCL), Fiserv (NASDAQ:FISV) and Stryker all made fresh 52-week highs. (Is it me, or didn’t Oracle just break $30 a few weeks ago—and it’s already closing on $35?)

Perhaps the best news of all came from Ford (NYSE:F). The automaker said it’s doubling its dividend. In the CWS Market Review from a month ago, I said it is possible Ford could sweeten its dividend, but honestly, I was expecting something minor. Not doubling! This is an excellent sign of confidence from Ford. The stock got as high as $13.94 on Thursday, which is an 18-month high.

The End of the Fear Trade

Before we get too carried away, I want to warn you that this is a tricky market. Last week, I mentioned that we’re witnessing a “high-beta rally,” which means that a lot of bad stuff is getting pulled along with the good stuff. Fortunately, we have the good stuff.

What’s interesting is that the most-hated stocks on Wall Street, meaning those that are “shorted” the most, have been doing the best. The folks who have been short this market have been getting squeezed. This means they have to cover their shorts, and that’s propelling those hated stocks even higher.

I’ll explain what’s going on with a simple example. Let’s say you have two stocks that are perfectly equal in every way. Same industry, same finances, same logos, you name it, they’re exactly alike. Both are expected to earn $1 per share this year. However, there’s one difference. Stock A is expected to earn $1 per share, plus or minus two cents per share, while Stock B is expect to earn $1 per share, plus or minus 30 cents per share.

So which stock is going to be worth more? The answer is that in most cases Stock A will be worth more. It’s not entirely logical, but investors are more scared of the downside than they are optimistic for the upside.

But here’s the important part investors need to understand: While Stock A will usually be worth more than Stock B, that gap will fluctuate a lot. Sometimes, the crowd turns fearful and the A/B gap will open wide. But other times, when folks are more confident, that gap will narrow. The A/B gap will move according to the crowd’s fear level.

Now let’s bring our thought exercise back to the real world. What happened over the past few years is that the whole world got terrified. The A/B gap opened to ridiculous levels. Any investment that wasn’t a surefire guarantee got dumped. It wasn’t just stocks: we saw it in bonds as well. High-grade corporates lagged Treasuries, and junk bonds lagged high-grades.

As the fear is slinking away, the fear gap is closing up. As a result, the Stock Bs of the world are outperforming the Stock A’s. Meaning that anything that’s seen as carrying higher risk has been doing well.

In the real world, we can see that in the fact that small-cap indexes like the Russell 2000 and S&P Small-Cap 600 have recently hit all-time highs, even though the S&P 500 still has a way to go to match its all-time high. Even the Mid-Cap 400 is at a new high. Last week, I showed you how well the High-Beta ETF has performed.

This chart shows you that since mid-November, small-caps have done the best, followed by the mids, followed by large. Performance has been perfectly ordered by size (or risk, B to A).

Let me caution investors not to be too impressed by some of the stocks that they’ll see rally. Facebook (NASDAQ:FB), for example, is back over $30. FB is horribly overpriced, and there are lots of stocks rallying that are even worse.